CONSEQUENCES OF DIVERSION OF FUNDS COLLECTED FROM PROCEEDS OF PRIVATE PLACEMENT

Private placement

Section 42 of the Companies Act, 2013 (‘Act’ for short) provides for issue of shares on private placement basis. A private placement shall be made only to a select group of persons who have been identified by the Securities and Exchange Board of India (‘SEBI’ for short) whose number shall not exceed 50 or such higher number as may be prescribed [excluding the qualified institutional buyers and employees of the company being offered securities under a scheme of employees stock option in terms of provisions of clause (b) of sub-section (1) of section 62], in a financial year subject to such conditions as may be prescribed.  A company shall not utilise monies raised through private placement unless allotment is made and the return of allotment is filed with the Registrar. 

Utilisation of fund

The amount collected through private placement is utilised according to the objects of the scheme.  There shall not be no variation from these objects.  If it is so, then it will be considered as breach of the provisions of SEBI and regulations made there under.  There shall not fraud or intention to fraud the stakeholders. 

In such an event the SEBI may initiate investigations on the breach of the SEBI regulations and may impose penalties and restricted the parties concerned from the trading in the securities market.

Diversion of the Fund

The diversion of fund of the private placement amounts to the breach of the objects and the provisions of Companies Act and SEBI Act and regulations made thereunder.  Diverting preferential/private placement proceeds to undisclosed objects constitutes a fraudulent and unfair trade practice under SEBI's PFUTP Regulations. A subsequent, post-facto resolution by shareholders ‘ratifying’ the diversion cannot cure the illegality or absolve the company of SEBI liability. This has been confirmed by the Supreme Court in the case law discussed below.

Case law

In Securities and Exchange Board of India Versus Terrascope Ventures Limited Etc. - 2026 (3) TMI 1086 - Supreme Court, the respondent Terrascope Ventures Limited (‘company’ for short) in the present appeal which is known as ‘Moryo Industries Limited’ in the earlier period, issued a notice for the conduct of Extra Ordinary General Meeting ‘EoGM’ for short) to its members and the public.  The purpose of the said meeting is to allot shares to non-promoters on preferential basis.  The number of the proposed allottees was 49 and the number of shares to be allotted is 74,50,000.  In the Explanatory Statement provided in the notice, the object of this allotment is prescribed.  The object of this issue is to fulfil the additional fund requirements for capital expenditure including acquisition of companies/business, funding long-term working capital requirements, marketing, setting up of offices abroad and for other approved corporate purposes.

A special resolution was passed by the company in the EoGM on 01.10.2012 for the preferential allotment.  The shares were allotted to 42 entities amounting to Rs.15,87,50,000/- between 16.10.2012 and 18.10.2012.

The Whole Time Member (‘WTM’ for short) of Securities and Exchange Board of India (‘SEBI’ for short) on 04.12.2014 passed an interim order restraining the company promoters, directors including the individual respondents herein, the preferential allottees and, certain group companies of the first respondent from buying, selling or dealing in the securities markets, either directly or indirectly, in any manner, till further directions under Section 11(1), 11(4)(B) and 11B of the Securities and Exchange Board of India Act, 1992 (‘SEBI Act’ for short). The above said order held that preferential allotment was used as a tool for implementation of the dubious plan, device and artifice of Moryo Group and allottees. 

The company had invested 66% of proceeds of preferential allotment in shares of listed as well as unlisted companies and rest of the money was given as loans and advances to certain entities. The special resolution passed by the company for the purposes of preferential allotment provides that the proceeds of this allotment would be utilised to meet the requirements of-

• capital expenditure including acquisition of company/business;
• funding long-term working capital requirements;
• marketing;
• setting up of offices abroad; and
• for other approved corporate purposes.

The company did not use the proceeds of the allotment for any of the abovementioned activities. The company did not have any business operation during the relevant period. 

On investigation it was found that companies in which the company invested were having common promoters and the loan granted were without the loan agreement.  From this it can be inferred that the entities, in which investments were made, were known or connected to Moryo. In the meanwhile, the said company made amendments to the objects clause of the Memorandum of Association to include financing, investment and share trading on 12.03.2014.  The Whole Time Member confirmed the interim order passed earlier on 22.08.2016.

On 29.09.2017 the company passed a special resolution for ratifying the diversion of funds.  On 29.05.2015, the respondent-company wrote a letter to the WTM of SEBI denying any diversion of the proceeds of preferential allotment to purposes other than stated in the objects of the EoGM.

On 15.12.2017. the WTM of SEBI issued a notice for violations of SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003  (‘Regulations’ for short), calling upon to show cause as to why suitable directions under Section 11B, 11(4) and 11(1) of the SEBI Act  be not passed against them for violations.  The respondents filed a reply to the WTM on 05.01.2019 which was rejected on 19.03.2019. The WTM found the Company had utilized the proceeds for the objects not disclosed in the notice of EGoM. However, since by the said date, the respondents herein had already undergone restriction from accessing the security market for a period of more than 4 years and 3 months, in view of the ad-interim order of 04.12.2014, no further penalty was imposed.

On 27.04.2018, the Adjudicating Officer (‘AO’ for short) of the appellant issued a show cause notice to the respondents calling upon the noticees to show cause as to why an enquiry should not be held for violations under Regulations 3(a), 3(b), 3(c),3(d), 4(1),4(2)(f), 4(2)(k) and 4(2)(r) of the Regulations. In the said notice, it was alleged that that the proceeds of the preferential allotment were immediately transferred to various entities inasmuch as while the proceeds were credited in the account of the company during 16.10.2012 and 08.11.2012. The same were transferred to various entities during 16.10.2012 to 09.11.2012.  The show cause notice further alleged that the proceeds of preferential allotment were not retained in the company for executing its objects.  The funds in the accounts of the company is not sufficient enough to transfer the amount to various entities.

The further notices issued to the company were returned undelivered.  However, the Adjudicating Authority fixed the hearing date on 24.07.2019.  The said notice was affixed on the last known address on 15.07.2019, thus effective service was made. The respondents filed a reply to the Adjudicating Authority on 22.07.2019.  In the reply it was stated that-

• Under the MOA advancing money to companies was permitted.
• Due to prevailing market conditions, the proceeds of the preferential issue could not be utilized as per the objects of the issue.
• In the year 2014 they altered the object clause to financial activities through a special resolution.
• The proceeds which were invested in shares and lent to other entities were received back and utilized as per the modified objects clause.
• The shareholders have ratified and approved the aforesaid utilization of the proceeds of the preferential issue by passing a Special Resolution in the Annual General Meeting (‘AGM’ for short).

The Adjudicating Authority on considering the reply filed by the respondents passed an order on 29.04.2020.  He imposed penalty of Rs.70 lakhs for violation of the regulations; penalty of Rs.30 lakhs for violation of Securities Contracts (Regulations) Act and listing agreement on the company.  The Adjudicating Authority imposed penalties individually on Directors for contravention of Regulations Rs.25 lakhs.  The Adjudicating Authority further held that fraudulent acts could not have been committed except with the knowledge of Respondents Geeta Manoharlal Saraf and Manoharlal Saraf, who were directors of the company and signatories to the financial statements declared by the Company in its Annual Report for 2012-13 and 2013-14.

The respondents challenged the said order before the Securities Appellate Tribunal (‘SAT’ for short).  The SAT allowed the appeal holding that once the utilization of the proceeds have been ratified by the shareholders of the company, the acts and deeds done by the Company becomes valid and authorized and therefore, there was no variation of the utilization of the proceeds.  Being aggrieved against the order of SAT, SEBI filed the present appeal before the Supreme Court.

The appellant SEBI submitted the following before the Supreme Court-

• The misutilization of funds is in violation of the Regulations, 2003 and Section 21 of SCRA and Clause 43 of the Listing Agreement.
• The proceeds of private placement were diverted to other entities and by way of loan and investments in shares which is in violation of PFUTP Regulations.
• The ratification dated 29.09.2017 is of no avail as Section 27 of the Act has no application.

• Section 27 of the Act applies only to variation in terms of contract or objects in prospectus.
• There is no provision under the Companies Act to ratify post facto diversion of funds raised through issue of any securities.
• As per Section 42(3) of the Act a Company making private placement shall issue private placement offer and application in such form and manner as may be prescribed.
• The timing of diversion immediately after the receipt, establishes fraud and violation of Regulations 3 and 4 of the PFUTP Regulations.
• Illegal and void ab initio acts cannot be ratified.
• The impugned order is wholly untenable and prayed for setting aside the same and restoration of the order of the Adjudicatory Authority.

The Supreme Court appointed an amicus curiae to help it.  The amicus curiae submitted the following before the Supreme Court-

• Though Section 27 of the Act on its terms and applied only to a prospectus, since Section 62(1)(c) of the Act which deals with allotments such as private placement makes compliance with provisions of Chapter III, the principles analogous to Section 27 would be applicable to the present situation when read with Section 62(1)(c) of the Act.
• The shareholders are entitled to grant a retrospective approval or make a ratification.
• So long as the variation does not contravene any law or the company’s constitutional documents, the Company must be treated as having the implied power to make such variation.
• Such power is being reasonable and incidental to achievement of its objects.

• Though the Memorandum of Association did not provide for lending as one of the purposes, there was no clause prohibiting the same.
• The ratification is valid since the breaches are in the interests of the shareholders. 
• No complaint has been received in this regard.
• Merely mentioning the wrong provision of Section 27 is not fatal for ratification. 
• The AO has not considered the contention of the noticees that all loans advanced have been received back by the company and that the investments made by the respondents had yielded positive results.
• Once the WTM had adjudicated the matter and returned findings it was impermissible for the AO to simultaneously adjudicate on the same cause, as such parallel exercise of jurisdiction leads to contradictory and inconsistent findings undermining certainty and regulatory discipline.

Therefore, the amicus curiae contended that the impugned order did not warrant interference.

The Supreme Court considered the submissions of the parties and amicus curiae and considered the question to be decided in the present appeal is as to whether the SAT was justified in reversing the order of the Adjudicating Officer, and exonerating the respondents for alleged violations of Regulations and the SCRA?

The Supreme Court analysed the provisions of the Regulations. The Supreme Court also analysed the objects of the SEBI Act and its Regulations.  The Supreme Court observed that the Act and Regulations are intended to pre-empt manipulative trading and check all kinds of impermissible conduct resorted by parties, so that the innocent investor is not misled.  The primary purpose of such statutory provisions is to provide an environment conducive to increased participation and investment in the securities market, which is vital to the growth and development of the economy.

The Supreme Court further observed that the protection of investors should necessarily include prevention of misuse of the market.  The proceeds of the preferential allotment got started.  The petitioners did not justify their stand that proceeds could not be utilized due to prevailing market conditions, the noticees have not elaborated as to what the market conditions were and as to what the difficulties were in meeting the objects of the issue

and the compelling reasons to extend loans and advances.

The Supreme Court has no doubt that the diversion of the funds, raised for an object not set out in the notice of EoGM was clearly in breach of Regulation 3 as well as Regulations 4(2)(f), 4(2)(k) and 4(2)(r) of the Regulations.  When a company offers private placement or goes public, the legal regime mandates fair disclosure and transparency. The investors and all other stakeholders concerned with the securities market irrespective of whether they ultimately subscribe to the shares or not, adjust their affairs based on the disclosure made.

The Supreme Court also analysed the Clause 43 of the listing agreement, Sections 21(conditions for listing) and 23E (Penalty for failure to comply with the listing condition or delisting condition or grounds) of the Securities Contract (Regulations) Act.  The LODR32(1) and 32(5) create a reporting obligation of deviations in the use of the proceeds from the stated objects.  This does not mean that this is a sanction for deviation but this mandates the reporting of deviation, to enable stock exchange. The Supreme Court also analysed the provisions of Section 32 – (Statement of deviation(s) or variation(s)) and Section 35 (Annual Information Memorandum).

The Supreme Court observed that the EoGM was held on 03.09.2012 for the stated objects therein. The funds started coming in from 16.10.2012. From the very next day, the funds were diverted towards advances to companies and for investment in shares. The ratification came after the WTM had passed an ex-parte order on 04.12.2014 only on 29.09.2017, at a point when the entire funds already stood diverted.  The Supreme Court did not accept the contentions of the company that the market conditions prevailing prevented them from utilizing.  It is very clear from the facts that the respondents had from the very inception had no intention to use the funds for the stated objects and their only object was to somehow raise the funds and divert it for the purpose they ultimately did.

Then the Supreme Court considered the decision of SAT which held that since the shareholders have ratified the Acts and Deeds done by the company, they become valid and

authorized and as such there was no variation in the utilization of the proceed.  The Supreme Court observed that the present issue of equity shares by way of preferential allotment to designated individuals is through private placement and under Section 42(8), no company offering securities on private placement shall release any public advertisement or utilize any media, marketing, disbursement channels or agents to inform public at large about such an offer. 

In the present case, the entire amount raised was utilized for a different object than the one set out in the EoGM notice and ratification was sought after committing the illegality. In view of the above, the reliance on Section 27 read with Section 62(1)(c) is completely misplaced.  By a private resolution, a liability which is crystalized cannot be wiped off by contending that the shareholders have condoned the action. When rights of multiple stakeholders are involved and certain Regulations proscribe a particular course of action any breach of the Regulation has to face its consequences.

The diversion was contrary to the object set out to the explanatory note and was before any amendment was carried out to the Memorandum of Association and the purported resolution of ratification dated 29.09.2017. More importantly, the diversion was contrary to the Regulations of SEBI, the SEBI Act and the disclosure norms under Section 173(2) of the Act read with Regulation 73(1) of the SEBI ICDR Regulations, 2009. Being a plainly illegal act impacting a vast array of stakeholders other than the shareholders of the company, the question of ratification cannot arise at all.

Then the Supreme Court analysed the validity of separate proceedings by the Whole Time Director and Adjudicating Officer.  The amicus curiae contended that the adjudicating order which culminated in the order of 29.04.2020, was found on the very same facts and allegations on which the WTM had on 19.03.2019 adjudicated after passing the ex-parte order on 04.12.2014. the AO was estopped from initiating proceedings on the same set of facts which the WTM had adjudicated.  The Supreme Court held that this submission is also misplaced.  The EoGM resolution is dated 01.10.2012 and the funds were raised between 16.10.2012 and 08.11.2012. The funds were utilized for the purpose other than the one set out in the explanatory memorandum between 16.10.2012 and 09.11.2012.  Thereafter on 04.12.2014, the Whole Time Member passed an ex-parte order against respondents, restraining them from buying, selling, anddealing with securities market either directly or indirectly in any manner till further directions. This was done to protect the interest of the investors. The ex-parte order was confirmed on 22.08.2016.  Thereafter, the appellant conducted a detailed investigation and a Show Cause Notice was issued to the respondents on 05.12.2017 calling upon them for alleged violation under Regulations.  An order was made after adjudication on 19.03.2019 and insofar as the present respondents were concerned, since by then these respondents had already undergone a prohibition from accessing the securities market directly or indirectly for a period of more than four years, the said period was held as sufficient.

Under Section 11(B), 11(4) and 11(1) of the SEBI Act, as it then stood, the WTM could only impose punishment of restraining access from the securities market and disgorgement of any profit made or loss averted. In the present case, for a transaction of this nature, only restraining from accessing markets could have been imposed by the WTM at that point and that was duly imposed.  Post the interim order by the WTM and based on the investigation for the purpose of imposition of penalty the Adjudicating Officer issued a Show Cause Notice on 27.04.2018 and it is out of this Show Cause Notice that the present proceedings arise. Section 15HA was amended in 2014.  When the matter was clear during the inquiry that there was a clear case for penalty, the AO stepped in and exercised jurisdiction and

passed an order for penalty. It is only that two authorities vested with different powers operating in separate fields have exercised jurisdiction during the period in question.

The Supreme Court also did not find the penalty imposed to be disproportionate.  In view of the above the Supreme Court set aside the order of SAT.

Conclusion

Emphasizing investor protection and market transparency, the Supreme Court ruled that the unlawful diversion of preferential issue proceeds could not be legitimized through subsequent shareholder ratification